How Does the 10 Percent 401(k) Tax Penalty Work?

by Tim Plaehn

How Does the 10 Percent 401(k) Tax Penalty Work?

The 10 percent tax penalty on 401(k) retirement plans may apply if you withdraw money from your employer-sponsored retirement savings account. As a young, working person, you want to be careful about making withdrawals from your 401(k) account. The tax rules concerning 401(k) plans list the types of withdrawals subject to the penalty and which types of withdrawals do not trigger the tax penalty.

Saving for Retirement

The purpose of a 401(k) plan is to provide a savings and investment vehicle to accumulate money toward your retirement. Workers are allowed to save money on a before-tax basis, and your 401(k) account grows tax-deferred. To discourage workers from using their 401(k) savings before retirement, the tax rules impose an extra 10 percent income tax penalty if money is withdrawn and used before retirement age -- defined as age 59 1/2. When you make withdrawals from your 401(k) account after you have retired, the withdrawals will be included in your taxable income at that time.

Penalty Plus Regular Taxes

If you withdraw money from your 401(k) account before reaching age 59 1/2 and do not qualify for any of the exceptions to the tax penalty rule, you must pay the 10 percent penalty on top of the regular income tax on the amount of the withdrawal. If, for example, you are in the 25 percent tax bracket, your total tax on the withdrawal would be 35 percent of the amount withdrawn. If you are in a zero percent tax bracket -- paying no tax on your regular income -- you must still pay the 10 percent penalty tax on the withdrawal.

Avoiding the Penalty

There are several circumstances that allow you to avoid the 10 percent penalty if you withdraw money from your 401(k) account. If the money is rolled over into another 401(k) or an IRA account, there will be no taxes due, including the penalty. Certain hardship conditions allow you to make penalty-free 401(k) withdrawals. According to IRS information, you must show "an immediate and heavy financial need" and not have other financial resources available to cover these expenses. Also, your 401(k) plan rules must allow hardship withdrawals.

Income Tax Withholding

If you make a withdrawal from your 401(k) account and it is not processed as a direct rollover to another qualified retirement plan, the 401(k) administrator will withhold a portion of the withdrawal for taxes. Have the administrator withhold the 10 percent tax penalty amount plus any additional taxes you expect to pay on the withdrawal. Then when you file you income tax return, you will not need to send any extra money to the IRS. If too much money was withheld, you will get it back as part of your income tax return.

References

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.